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10/05/2008

Equities, Pay Caps, Liquidity: Structuring a Bailout--Posner

I want to comment on Becker's post, of course, but I will also take the opportunity to respond to one of the themes in the very interesting comments that readers of our blog made on my post of last week.
I agree completely with Becker that the government should not in general have an ownership interest in private companies. The "in general" qualification is intended in part to approve of allowing the government to acquire such an interest temporarily, as part of the current bailout (for reasons I explain below); and in part to leave open the question whether the Social Security Administration should be permitted to invest some of its funds in the stock market; if the investment were spread over the entire market, so that SSA had only a very small stake in any given firm, the influence of government on firm management would be small. I would worry, however, that it would grow and turn out to be an entering wedge for socialism, but that is a story for another day.
I also agree that caps on the salaries of the executives of banks that participate in the bailout are dumb. Not only are such caps bound to be evaded, but if they were not evaded they would have the curious effect of subsidizing mediocrity. Capping the salaries of the executives in one industry will drive out (and deter from entering) some of the ablest executives, creating a space that will be filled by mediocrities. The allocation of talent across industries will be distorted and the recovery of the financial sector retarded.
Where I differ from Becker is with respect to the question whether the government should demand common stock in the banks it buys assets from. I think it should (as it is authorized to do by the bailout law just enacted).
The reason goes to the heart of the justification for the bailout. The banks are holding assets of dubious value. This makes them reluctant to lend money, because as I explained in my last post what banks do is borrow (for example, from depositors) and then lend the borrowed money, and they need a capital cushion against the possibility that the people they lend to will default. The smaller the cushion, the more conservative a bank‚Äôs lending policy must be.
If the government in executing the bailout buys the bank's bad assets at prices equal to their true, low value, the bailout will have no effect (with a qualification, concerning liquidity, noted below). A bank will be exchanging an asset worth say $1 million for $1 million; its capital will be no greater, and so neither will its willingness to lend be any greater. The bailout will work only if the government overpays. Suppose it pays $2 million for an asset worth only $1 million. Then it has added $1 million to the bank's capital. That capital is owned by the bank's shareholders. The government's purchase of the asset will therefore have enriched the shareholders.
Moral-hazard issues to one side, why should the taxpayer be enriching shareholders? The alternative is for the government to say to the bank in my example: we will pay $2 million for your lousy asset but in exchange we want you to issue us $900,000 worth of stock. (Not $1 million worth of stock, for then the bank might have no incentive to make the sale--or might, as the capital infusion could help it to stave off bankruptcy.)
I anticipate the following objections: (1) The banks will not participate. But why not? They would not only be making money on the deal; as I just mentioned, by strengthening their capital base they would also be reducing the likelihood of bankruptcy. (2) Government should not have an ownership interest in private companies. I agree, but this would be a temporary interest; the government would sell its interest as soon as it could find a private purchaser. (That was what happened in Sweden after it bailed out its banks from a crash similar to ours in thr 1990s. See Joellen Perry, "Swedish Solution: A Bank-Crisis Plan That Worked," Wall St. J., Apr. 7, 2008, p. A2.) (3) The taxpayer can recoup completely without the government's taking an ownership interest because the problem is not that the "bad" assets are so bad, as that they are illiquid; the bailout will restore liquidity without adding to bank capital.
The third point is the most important, and let me pause on it. The idea behind it is that the value of the "bad" assets that the banks hold is unnaturally depressed by the panic that has seized the financial industry. The bailout will dispel the panic and so restore the "bad" assets to their true, "good" value. The government will need only to hold the assets until their maturity and it will be able to sell them then at a price equal to or even higher than the "excess" price that it will have paid for them during the bailout.
The objection to this analysis is that if the situation is as depicted, there should be more private buying of bad bank assets than we are observing. Buffett should be investing not only in Goldman Sachs but also in hundreds of other financial institutions. There is plenty of global capital and why isn't more of it going to the purchase of bank assets whose true value is greater than their current market value? The bailout makes most sense if hundreds or even thousands of banks (there are more than 8,000 banks in the United States) really are broke or nearly broke, so that credit will dry up unless there is a massive infusion of capital into the banking industry. The fact that the required infusion is coming from the U.S. government suggests that the global capital markets are not confident that they could recoup investments in buying bank assets.
But this objection is not conclusive. It is possible that the banks' problem is not, or at least not only, undercapitalization because of the decline in the value of their assets, but lack of liquidity, which is different. Suppose you have a very valuable asset but all of a sudden the government decrees that money is no longer legal tender--that all transactions henceforth must be in bamboo shoots. Now, though your asset was valuable before the decree and will again be valuable when the decree is lifted, at the moment there is no market for it. If you do not know when the decree will be lifted, you will be very reluctant to make loans, because you will not know whether, if a loan goes sour, you can sell or borrow against your assets in order to cushion the loss and avoid bankruptcy.
If that is the problem, the bailout may restore liquidity and thereby enable banks to sell or borrow against assets on the basis of their true value, and eventually the government will recoup the cost of the bailout, because it will own those assets and can sell them, when markets return to normal, for at least what it paid for them. But probably the banks' problem is a combination of undercapitalization and illiquidity. Their assets include assets whose value is tied to mortgages, and the value of mortgages has declined because of increased risk of default as a result of the bursting of the housing bubble. Insofar as the bailout helps banks to overcome undercapitalization as well as illiquidity, it will be enriching the banks' owners--unless it demands common stock in partial compensation for its buying the banks' questionable assets for more than they are worth.
The theme in the readers' comments to which I would like to respond, and it is also a theme in the Wall Street Journal's editorial comments on the financial crisis, is that government policy, rather than the free market, is responsible for the crisis--government policy in the form of encouragements spurred in part by Congress to home ownership through the government-chartered though private Fannie Mae and Freddie Mac home-mortgage companies, low interest rates imposed by the Federal Reserve Board, and lax supervision by the Securities and Exchange Commission and other regulators. I wish it were true. And what is true is that the government, including Congress, the Federal Reserve Board, and the SEC, were complicit in contributing to or creating some of the preconditions for the crisis--cheap credit and lax regulation. But there is a difference between creating and merely exacerbating a crisis. Moreover, it is a paradox to exonerate the market on the ground that the government did not do enough to regulate it!
I believe that the basic causes of the crisis were six factors internal to the market system. The first was abundant and therefore cheap global capital--the result of private economic activity--and, consequently, low interest rates, which encouraged borrowing. The second factor was a housing bubble caused in part by those low interest rates and in part by aggressive marketing of mortgages. The third was new financial instruments that businessmen believed reduced borrowing risks and so increased optimal leverage. The fourth was the difficulty of "selling" a conservative business strategy to shareholders in a bubble environment. Borrowing more and more at low interest rates while home or other asset values are rising enables financial institutions to make higher profits, and a firm that refuses to jump on the bandwagon will as a result experience lower profits and will have difficulty convincing shareholders that they really are better off because the higher profits of the competing firms are unsustainable.
The fifth factor was sheer uncertainty--was it a bubble? If so, when would it end? Would the new financial instruments assure a safe landing if it was a bubble and it burst? And the sixth factor was that the downside risk to highly leveraged financial institutions was truncated by generous severance provisions for their executives, authorized by boards of directors that were not effective monitors of executive decisions.
Cycles of boom and bust are intrinsic to capitalism. Government can make them more serious, and sometimes less serious, but if you take away government you will still have periodic economic crises.

This may be a Joe Six Pack analysis, but if there's a shortage of loans isn't the usual solution a rise in the interest rate until demand for loans decreases or savings increase? I feel like the American people still have money they could lend.

Posner: I also agree that caps on the salaries of the executives of banks that participate in the bailout are dumb.So if Bush had been paid more, he would have been smart enough to see the financial collapse coming and would have taken steps to prevent it?The idea that leaders will make better decisions if they are paid more is a lot like the idea that medieval kings would make better decisions if they were allowed to build luxurious castles for themselves and eat off gold plates. At the end of the day, you don't attract better kings, you just attract people who like to eat off gold plates.The key innovation of democracy was recognizing that you don't want decisions to be made by some single maximally "superior" person: you want the decisions to be made by a system. You don't want the king deciding whose head to chop off based on his "gut": you want a system of laws and judges and lawyers and juries.If a company needs the assembly line to be more productive, it doesn't pay the workers more: it hires more workers. If a company needs to be making better business decisions then it should expand it's leadership staff to include more analysts and experts with the relevant expertise.Excessive executive compensation is more the symptom (of a medieval approach to leadership) than the disease but it is ridiculous to claim that excessive levels of executive compensation serve some sort of useful purpose.

I am still not buying it. Six factors or sixty! Even if I accept the excessive risk model created by these factors, that is still risks, not failures! The cause of the failure (or loss) is due to the fact that we have loans that are bad. Tons of them. In good times or bad, there are always loan defaults. But the fact that the Congress had more or less beaten the banks into writing loans to people who have no prospects of servicing the loan was the real reason for the mess. The risk model amplifies and spreads the mess; that much is true.

Sure, Congress did not write laws that said that bank must loan money to those who could not pay it back. But when bank presidents were constantly threatened with legal actions or onerous regulations unless they could show they made as many loans to poor neighborhoods as in wealthy neighborhoods, could we expect anything different? Especially if you turn loose your mortgage salesmen and tell them to relax the lending criteria.

Sorry, Judge. You are still refusing to call the advocates of the liberal agenda to the carpet.

I also take issue with your defense of the Government taking equity stakes in "private" companies on a temporary basis, although your famous economic analysis seems to support the model. First, it creates a bad precedent. It is also not clear that any "exit strategy" will work. The government might end up finding itself unable to unload the equity because the business entity continues to be unattractive, but is always too large, or too government-involved, to fail. Sort of like the war in Iraq. This is not like the government is buying a few hundred shares‚Ä¶I have never seen a government-owned company make money. Anywhere. Ever.

I think the approx $12 trillion in US mortgages outstanding is backed by about $6 trillion in post-crisis home value. About 50%.

If this is true, than one inevitable purpose of the bailout is to allow the Gov't to choose which financial institutions will survive or not.

I would far prefer the gov't to be offering 50% of the last mortgage price for all foreclosed properties -- putting a floor under housing, and making the value of the MBS less uncertain.

Of course, most homeowners would be demanding a new, much lower mortgage. And they should.
The biggest failure of the bailout is that it doesn't push the banks to offer lower cost mortgages for the same houses that are now worth much less, if not worthless.

I'm gonna guess the judge's point about the UNwisdom of trying to legally limit exec comp at financial firms is that they already operate too much like a United Nations of Banana Republics for it to do any good. Like the old saw about the guy who spends $500K to run for a city council seat that pays $50K ABOVE the table, no telling how much below (til somebody snitches him out). That's one more risk the system doesn't need with $350 Bil in new cash to be sloshing around in a matter of weeks.

It is a political season, so I think so many people are looking for election-related answers to these questions. Posner is right, however, that government does not cause boom and bust. Thank God government does not control our economy. Capitalism is not smooth sailing; there will always be ups and downs; risks and rewards; fortunes made and fortunes lost; businesses born and businesses spectacularly fail. Governments are able to magnify or ease a crisis, but they rarely create them from scratch or prescribe a cure-all that makes the bust system go away.

I'm one of those who thinks Judge Posner wrong on government's role in causation. If the government agrees to insure all (or at least a sizable portion of) the bad paper you write in the express interest of achieving a political goal and succeeds, they are more than merely complicit. One must concede there's plenty of blame to go around both public and private, here. Nevertheless, to say that government encouragment of certain corporate (or quasi-corporate in this case) actions in pusuit of political aims does not cause those actions when they occur, is a kind of hairsplitting that, at least, borders disengenuousness.

In both 2003 and again I believe in 2005 the Bush administration (for which I have little love and almost no respect), claiming to be alarmed by the purported accounting irregularities that drove former management (Franklin Raines) out of Fannie Mae, did, to their credit, attempt to have Congress put the brakes on that runaway organization. The proposed legislation was killed in committee on strict party line votes both times. Demonstrating, once again, the incomptency of politicians in regulatory or commercial arenas.

And no one exonerates this market based on the failure of government to properly regulate it. Still, regulatory failure is a failure of government and a reason not to trust the government to solve a crisis they (at least in part) caused and failed to ameliorate by useful regulation.

Democratic governments should not own companies. Heavens knows they have a tough enough time finding concensus to govern. They will never find consensus to run the companies satisfactorilly and what consensus they will find will be political, not economic. Just like with Fannie Mae that they didn't even own, just performed "oversight functions". It is no solution to poor coprporate decision making (of which there's plenty in this current situation) to substitute even worse political decision making.

And it's OK if it's temporary? If it's a bad idea, it's a bad idea. Hanging is no less bad if you only do it for a short time. And what makes you think it'd be temporary? A bureaucracy would be created to manage these assets, no? And when, I ask you, in the entire history of human affairs, has any bureaucracy ever voluntarilly limited either it's scope or duration?

> Suppose you were an idiot.
> And suppose you were a member of Congress....
> But then I repeat myself.
> -Mark Twain
>
> I contend that for a nation to try to tax itself into
> prosperity is like a man standing in a bucket and trying to lift
> himself up by the handle.
> Winston Churchill
>
> A government which robs Peter to pay Paul can always depend on
> the support of Paul.
> George Bernard Shaw
>
> Democracy must be something more than two wolves and a sheep
> voting on what to have for dinner.
> James Bovard, Civil Libertarian (1994)
>
> Foreign aid might be defined as a transfer of money from poor
> people in rich countries to rich people in poor countries.
> Douglas Casey, Classmate of Bill Clinton at Georgetown
> University
>
> Giving money and power to government is like giving whiskey and
> car keys to teenage boys.
> P.J. O'Rourke, Civil Libertarian
>
> Government is the great fiction, through which everybody
> endeavors to live at the expense of everybody else.
> Frederic Bastiat, French Economist (1801-1850)
> .
> I don't make jokes. I just watch the government and report the
facts.
> -Will Rogers

> If you think health care is expensive now, wait until you see
> what it costs when it's free!-

P.J. O'Rourke

> In general, the art of government consists of taking as much
> money as possible from one party of the citizens to give to the
> other.
> -Voltaire (1764)

> Just because you do not take an interest in politics doesn't
> mean politics won't take an interest in you!
> -Pericles (430 B.C.)

> No man's life, liberty, or property is safe while the
> legislature is in session.
> -Mark Twain (1866

)
> Talk is cheap...except when Congress does it.
> -Unknown

> The government is like a baby's alimentary canal, with a happy
> appetite at one end and no responsibility at the other.
> -Ronald Reagan

> The inherent vice of capitalism is the unequal sharing of the
> blessings. The inherent blessing of socialism is the equal sharing of
> misery.
> -Winston Churchill

> The only difference between a tax man and a taxidermist is that
> the taxidermist leaves the skin.
> -Mark Twain

> The ultimate result of shielding men from the effects of folly
> is to fill the world with fools.
> -Herbert Spencer, English Philosopher (1820-1903)

This bailout is just one more example of the indivisible handjob stroking irresponsible CEOs and CFOs with billions so that they can run the American economy even further into the ground. So much for Keynesian economics. If the goal is to stimulate the economy, why not give the money directly to the American taxpayer? A bird in the hand is worth two in the bush administration.

What I see as the key difference between free-market advocates who oppose the bailout and those who support it is focused on this passage from Posner's most recent post:

"The third point is the most important, and let me pause on it. The idea behind it is that the value of the "bad" assets that the banks hold is unnaturally depressed by the panic that has seized the financial industry. The bailout will dispel the panic and so restore the "bad" assets to their true, "good" value. The government will need only to hold the assets until their maturity and it will be able to sell them then at a price equal to or even higher than the "excess" price that it will have paid for them during the bailout."

I would argue that Judge Posner has it exactly backward. The prices have fallen to their real level after being artifically inflated. The bailout freezes the higher prices and misallocation of resources in place. Why do I say this?

Relying on the Austrian view of the business cycle (see F.A. Hayek's *Prices and Production,* 1931 and *The Pure Theory of Capital,* 1941) the Federal Reserve's artificially lowering the interest rate to stave off deflation (in the sense of the stock of money falling) in the earlier years of this decade induced an overinvestment in certain sectors of the economy. In our present situation, the money flowed to housing facilitated by governmental efforts to increase housing for low income minorities. There is no question that the Fed followed this policy.

Due to the overinvestment in housing, the price of real estate rose dramatically. The dynamics that drove up house prices that Judge Posner describes did occur. But it was brought on by the Fed's monetary policy leading investors to believe that there was sufficient real demand and real savings to support the upward movement in the housing market. According to Austrian theory, when the central bank takes on itself the responsibility to stimulate the economy without regard to real factors of demand and savings, the lower interest rate misleads investors to invest too much and produce the good at rates higher than can be sustained over time.

If Hayek's analysis were not accurate, why did so many skilled entrepreneurs and investors have such a terrible misperception of the market simultaneously when they have a track record of making sound judgements? I agree that the newer financial instruments made this problem worse. But I would argue that Judge Posner has again reversed relevant factors causing the crisis--here he has reversed the root cause and a contributing factor.

Of course, not bailing out the banks is likely to bring on a credit crunch and a recession.
With the bailout, we are likely to simply push the problems off into the future bringing us either inflation to pay off the debt or a recession when the inflation ends (if it did not end, then we would get hyper-inflation). We are already getting inflation now from the previous monetary expansion. We may get stuck in stagflation for a while--then either recession or inflation (due to either a constrictive monetary policy or an expansionist one to delay a downturn). The recession is coming no matter what. It is just when we want to take it.

The cause was not the market but the overexpansion of credit by the central bank. Some of the dynamics of the market exacerbated the misdirection of economic actors brought on by Alan Greenspan's fear of deflation ala Japan and the Great Depression. What monetarists overlook is that if the stock of money falls dramatically and prices are allowed to fall in a proportionate manner, then the economy will correct itself. Perhaps, we should listen to Dr. Phil instead of Dr. Greenspan when Dr. Phil says, "whatever you fear most, you will bring about."

"Cycles of boom and bust are intinsic to Capitalism". This sounds like Schumpeter and Kondratiev Wave Theory. Specifically, Long Wave Theory and it's modern development by Marchetti & Modis. It may very well be. Yet, we still need to minimize the impact on the Social order and population at large. Clearly, we can't depend on the Finacial Industry to take care of it. They're the ones in trouble, or Wall Street, they are not too far behind. So who's left? The U.S. Government. For better or worse.

As Robert E. Lee so aptly muttered at the beginning of Gettysburg, "God's Will".

Neilehat, I think you are on to the underlying problem more broadly conceived. We have turned away from God in the United States and Europe. We fail to see the rational order of the universe, both in the physical world and in the social world as evidence of the Divine. In fact, we can see it if we open our eyes and minds to what lies before us. Instead, we believe that we can defy the order God gave us and insulate ourselves from the fallout. We think we can control things and manipulate people as if they were objects in a room. Then when our own manipulations reach a breaking point as we defy the rational principles that God gave us to live by, we are left in confusion and in the wake of the destruction we set ourselves up for.

Below is a link to Frederick Hayek's Nobel Prize lecture, "The Pretense of Knowledge." I am afraid that the Chicago School monetarists have fallen into the hubris that Hayek discusses in his lecture. Certainly, the Keynesian Revolution did.

As Bernard Levy said mocking Nietzsche, "God is dead, Marx is dead, and I am not feeling so well myself." We can add Keynes and now Milton Friedman to Levy's roll call. When we found God to be irrelevant for modern man, something died inside us and the corpse is Western civilization.

General Lee pushed it too far at Gettysburg because he thought the Army of Northern Virginia was invincible. Perhaps God is speaking to us now in our failure as he did the South in defeat.

As a 23 year old law student about to enter this fledgling workforce, I feel that the source of this economic calamity goes much deeper than financial instruments or government (in)action. In my opinion, what got us to this point is not inaccurate interest rates or poorly regulated mortgages. Our mistake was in believing that "If we can just tweak interest rates or decrease inflation or blah blah blah," it will all balance out. Our mistake was in trusting that the hypercomplex jargon being tossed around by snakes in suits was valid simply because it seemed over our heads and their suits were nice. This country was founded by hardworking farmer folk with callused hands in home-stitched clothes. It was their dedication to community, justice and family values that took us from a newborn democracy to a global superpower in just two centuries. But we all agree that power can be a double-edged sword, and I feel we're just now starting to feel the cut from the other side of that sword. America would currently best be caricatured as a rich fat kid who lies around on the couch demanding global prominence without ever wanting to lift a finger. The financial industry is a perfect reflection of that - we don't want to have to create new things or contribute energy - we'd rather just lie around on the couch and "let our money work for us."

I believe the end of the 20th century produced a generation of snakes in suits who justify their own immorality as "the American way." As we speak, hundreds of millionaires who have never worked a day in their lives are slithering around Washington, STILL trying to tweak financial instruments so that the corporations who bought their Seat stay in the black. Maybe I'm naive, but I have a feeling that deep down inside each one of those snakes is a family man or woman who entered the public service arena to protect the interests of their loved ones. Somewhere along the line, they sold out to corporations in the mistaken belief that corporations have our best interests in mind. But a corporation (at least the 20th century version) only has one interest - BOTTOM LINE SHORT TERM PROFIT. So the snakes got what they wanted - bottom line short term profit. In the meantime, they've neglected the generations to come and in many cases the Constitution that gave them any power in the first place.

No, the changes that need to take place before this country ever restores itself to global prominence are not going to be found in the minds of Harvard Business grads. As phony as it sounds, the Best Bailout Plan we have lies in the hearts of every American who is only being further fattened by all of this government intervention. Washington is showing a grave lack of faith in the resilience of the American people by "saving" us from that looming D-word we're all so afraid to confront. Let us feel a depression. It may not be what's best for your kid's trust fund, but in the long run it will wake us up to how off course our system is. And somewhere in the heart of every fat rich kid on the couch is a fighting, innovative spirit that will one day "bail us out."

It doesn't take a Masters in Economics from Yale to know that you can't create capital out of thin air, which is precisely what all these complex financial instruments are designed to do. As a 23 year old, I'm part of a generation that just can't wait for the baby booming Gordon Gekkos to croak & turn over the keys to the White House. Thanks to information technology, our generation is more informed as young adults than those snakes in suits are in their old age. We understand the dynamics of the global economy, and as I wrote on the final page of a book I just self-published: "Intelligence - Surge. Disciplines - Merge. First Generation of Global Citizens - Emerge." So until the snakes in suits all clear out of Washington, we're just going to keep blaring our dirty rap music & communicating on MySpace. If you guys ever want our attention, us dumb poor kids who were once revered as the American people, just text us. Or do you know what that is?

Whether the government will or will not actually make money on these assets, I believe you underestimate the market problems created by the negative "animal spirits" out there w/r/t these assets. Many of these assets are trading far below what a simple discounted cash flow analysis would suggest is their value-- even assuming foreclosure rates substantially higher than likely.

That suggests that investors and managers of investments are showing the kind of avoidance of volatility and uncertainty that has been shown by Tversky and Kahneman.

Taylor, I take it you've never lived through, seen, experienced or studied Depressions and their impact on Social and Indvidual Psychology or the Socio-Economic Order in general. Wishing a Depression on someone is like wishing a Nuclear War on someone so that it will "toughen" them up.

That's the attitude the Nazi's and Japanese War Mongers had about us, not too mention Al Qaeda. Guess they found out differently. The majority of us are tough enough as it is. We certainly don't need a tough love program to make us stronger.

Now that you've finished Law School, welcome to the real world. Where you are about to have to re-learn "everything".

The medical profession or if you wish the healthcare industry has become so complex and post modern that the physicians have given over control of most of the process, input and output, to others by virtue of excessive division of labor. Perhaps not intended but a reality nonetheless. Perhaps the same dynamic is extant in our political and financial lives vis-a-vis the average citizen. Has anyone ever developed a curve to suggest that the relationship between complexity, division of labor and efficiency reaches a point of failure or inverse proportion? As an aside, I might also add that every modern ethicist, regardless of their theory or persuasion, would find those responsible for this mess utterly immoral.

Great post.
For further research it might be helpful to look at the way the Israeli Government delt with its banking crsis in the mid 80s (referring to the third point in the post). The Government offered to buy the stock from the shareholds in exchange for bonds - and made alot of money in the proccess. so buying the stock might not be such a bad idea after all.

Jim, good trial lawyers and able judges belly-ache every day about the civil justice system's exorbitant costs, inefficiencies, and diminishing returns. Corporate America is now spending more money to monitor and preserve electronically-recorded information that might become discoverable in a lawsuit than on product/service improvement and compliance aimed at averting litigation.

Q1. Why isn't the financial crisis on Wall Street palpable on Main Street? Although financiers, journalists and politicians have been warning of a major financial crisis, as big as the Great Depression, since August 2007 (some economists have been warning for several years now), normal economic activity seems unaffected, or at least the common man does not seems to feel any impending doom. Why is this so?

A. To a large extent, the current financial crisis does not involve the working capital of the American economy. The funds available with the commercial banks, community credit unions and credit card companies have been sufficient to keep business investments, payrolls and consumer spending going on in the near-term. Sure enough, the persistent gloomy predictions on the economy seen in the newspapers and television channels, throughout the year 2008, would have had a negative effect on the confidence of the consumers and the business entrepreneurs. This would have led to cutbacks in production plans, tightening of credit, mark-down of inventories and penny-pinching of family budgets. But, on the whole, the real economy has shown unexpected and prolonged resilience. No doubt the action of the US Federal Reserve Bank to pump over one trillion dollars into the economy for over-night and short-term lending has also eased the flow of money. But, the main reason for the disconnect between Main Street and Wall Street is that the financial crisis is concerned with the accumulated capital (as opposed to working capital) of the American economy.

The term accumulated capital refers to the capital held by (i) pension funds which hold the life-time savings of Americans, (ii) reserve funds which hold the accumulated profits of large corporations and private companies, (iii) mutual funds and money-market funds, which hold savings of individuals that are in excess of mandatory life-time savings like social security, and are more freely invested in the markets expecting a better return than from treasury bonds, (iv) endowment funds, held by private trusts, which are collected through charities and donations, (v) hedge funds and private equity, (vi) any other entity that holds capital that has accrued through the savings of individuals, or the profits of private organizations, or the surplus of state, local and federal governments, and is not needed as immediate investment for the day-to-day functioning of the economy.

To provide a perspective on accumulated capital, one may note that the financial wealth in the American economy is estimated to be $40 trillion (ref: Wall Street Journal Oct 1, 2008 article by Professor Edmund Phelps). Wikipedia states that the world-wide value of all pension funds are in excess of $20 trillion; mutual funds total more than $26 trillion. Please note that it is possible that some of the pension funds are invested in mutual funds. Also, I am not aware of what is the exact total sizes of pension funds, mutual funds and other constituents of accumulated capital within America per se, but I would assume that they add up at least to $10 trillion (which, I suppose, is included in the $40 trillion quoted above). In additions, hedge funds have about $1.5 trillion under their management totally, all of which is investments from individuals of high net worth.

Q2. Aren't saving for retirement, insurance and pension systems old phenomena? Why did they bring down Wall Street this time?

A. Yes, pension and insurance systems were already well-developed in the industrial economies of 19th century Europe. There are two major differences this time around. Demographically, the senior citizens of 19th century Europe retained close ties to the younger generations because of genetic, ethnic and racial homogeneity. As a result, the pension amounts received by the retired people were substantially supplemented by contributions from inter-generational and intra-family transfers of wealth. If we go back a hundred or more years, old people lived with their families and helped to bring up their grandchildren. Moreover, hereditary transfer of wealth was still as important as creation of new wealth in the industrial economies of the 19th century. These factors served as economic incentives for the working adult population to provide old-age care for their parents, which supplemented the parents' income from pension. The second difference is that the dichotomy between an empire and a democracy was far more prominent among the nations of 19th century Europe. People felt assured that the social infrastructure provided by an empire would safeguard their standard of living through their old age. Examples of the social infrastructure of an empire during 19th century Europe are the establishment of universal heath care, the administration of the pension and life insurance systems, and subsidized public transport and postal systems. As an aside, it may also be mentioned here that the development of the modern university was pioneered in Germany during the 19th century.

Thus the fundamental reason for the current financial crisis is the time value of money. To maintain the standard of living that people who are close to retirement or have already retired would expect, the income from their pensions have to be substantially larger, in view of the reasons discussed above, than what a senior citizen in 19th century Europe would have received, even after adjusting for inflation and GDP growth. This enhanced pension income would have to come from interest on investments, because the senior citizens who receive them could not possibly compensate for this income with active work. Thus the managers of pension funds found it imperative to look for high returns on their investments. At the same time, since these funds were so huge and so critical to the lives of many millions of people, their investment strategy had to exercise the utmost caution. Diversification served as the compromise in this situation. The managers of these huge funds would invest the major part of their portfolio safely, for example, in treasury securities. A smaller part would be put under the stewardship of the Wall Street firms for more risky investments in the expectation of high returns. Over a period of two or three decades, such unreasonable expectations on Wall Street to keep generating high returns on capital took its toll.

Q3. How exactly did unreasonable expectations bring down Wall Street?

A. When one refers to Wall Street, it is important to keep two types of people in mind. The first type is the senior executives who have gained their credentials through many years of involvement in the traditional roles of investment banking, beginning in the 1950s or later. The conventional wisdom among these people places a lot of importance on trust-worthiness, reputation, people-skills and management techniques as the path to career-success. Advising industrial firms in mergers & acquisitions, underwriting the issuance of company stocks and bonds to the public, helping the government finance a deficit through the purchase of treasury securities for their clients, and trading in securities on behalf of their clients were the main activities of Wall Street firms before the 90s. We note that all these activities required trust-worthiness primarily, and moreover they didn't require much of the firms' own capital. The second type is the smart, innovative PhDs who have arrived on Wall Street starting from the 1980s. These people have helped build the massive computational infrastructure on Wall Street along with the development of financial innovation. Their most valued skills are quantitative and they are quite tech-savvy. On the downside, many of the senior executives making up the first type have come to exercise a lot of political influence which could be illegitimate sometimes. For their part, the tech-savvy 'quants' of the second type have grown-up with post-modern, anti-heroic sensibilities that has no use for honor or reputation, as defined conventionally. However, in spite of their differing attitudes towards reputation and the 'word on the street', when it comes to compensation, both the types would like to cash in on their professional worth right away with large bonuses.

The advent of computers transformed the industrial economy into an information-based economy. This meant that smart people who could devise intelligent strategies to take quick advantage of the flow of information could expect to make large profits, especially from financial investments. Thus, starting in the early 80s, Wall Street investment banks began to make huge profits, aided by their large investments in computers and their new army of smart PhDs. Over the course of the 80s and 90s, the capital in the 'bulge-bracket' investment banks grew from a few tens of millions to one or two dozen billions dollars. The capital in the smaller investment banks and hedge funds on Wall Street produced similar returns. Thus Wall Street turned into a sleek and mean money-making machine. It was for its massive returns on capital that the managers of pension funds and other sources of accumulated capital had been turning steadily to Wall Street. The boom in the technology stocks during the 90s turned the trickle of capital to Wall Street from these fund-managers into a flood. Now, as history would have it, the technology sector went bust in 2000 with the NASDAQ composite index losing more than 60% of its value between 2000 and 2003. This drastic loss of wealth exposed an inability of modern finance theory to figure out how to determine the proper economic value of technological progress. There was a big question about how Wall Street could continue to churn out its massive profits. It was in this scenario, that the smart PhDs on Wall Street stumbled on the great innovation to direct the huge sources of accumulated capital in America and the rest of the world towards solving the long-term demographic incongruities in America. This was how Wall Street came to trade in mortgage-backed securities. In the process, they found a way to keep the money-machine that is Wall Street hum along smoothly for another 8 years.

Now, the smart PhDs that form the second type came up with a lot of innovations to carefully control the risk involved in turning a housing mortgage loan into a hierarchy of claims on payments, called tranches. For their part, the senior executives that form the first type, who had built up a reputation for trust-worthiness over several decades, could borrow money from the pension funds and other sources at leverage ratios of 25 to 30 -- far in excess of the reserve ratios expected from the commercial banks under the regulations of the Glass-Steagal act. This unlikely marriage of old wise-heads and smart innovators on Wall Street was sanctified by the Federal Reserve which kept interest rates low to avoid a slowdown in economic activity, given the tragedy of 9/11. However, from 2007 onwards, cracks in the marriage began to appear one by one, and it became apparent that the party had gone on too long. The smart PhDs had not take into account that the process of securitization separates the property rights on mortgaged homes from the investments on mortgage securities. The home-owner lives under the threat of foreclosure. So, his/her property rights are compromised. The security-owner bears liquidity risk and credit risk. So, his/her income is uncertain. It is plausible that left to themselves the smart PhDs would have, in due course of time, overcome their error by devising a market-based solution that would mutually alleviate the grievances of the home-owner and the security-owner. However, the Wall Street money-machine was on high-gear by then, and it was not designed to slowdown for any eventuality. The senior executives, who were more comfortable with people-to-people communications rather than arcane finance theory, ran to their long-established connections in the political establishment and the media. Moreover, these senior executives decided to play smart. They used the very same unreasonable expectations that society had placed on Wall Street as a bargaining chip to hold society to ransom. Their constant chants were "Bail-out Wall Street, for otherwise there is the 'systemic risk' of a financial meltdown". "It's going to be armageddon, so raise FDIC insurance to $ one million" (CNBC's Jim Cramer). "We're going to see a repeat of the Great Depression's bank runs". Unfortunately, the long sage of bail-outs starting with Bear Stearns in March 2008, then Fannie Mae, Freddie Mac and AIG in September 2008 and finally the $700 billion bill passed now have not stemmed the financial crisis, and the reputation of Wall Street is in tatters. Thus Wall Street was brought down by unreasonable expectations.

Q4. So what about the billions of losses due to mark-to-market accounting rule? Could these losses lead to financial meltdown? Also, why is de-leveraging cited as a reason for the huge losses? Why is re-capitalization of the banks necessary?

A. In view of the explanations above, it is far simpler to think of the situation as follows. The 'bulge-bracket' Wall Street investment banks (that have now been converted into bank-holding companies or have gone bankrupt) had about $20 to $30 billion of capital each. Wall Street was so used to annual returns of 20% or more on capital before the collapse of the technology sector in 2000. To maintain this high rate of return after 2000, the investment banks resorted to leverage ratios of 25 to 30 in their investments on mortgage securities. This means that each of them borrowed about $750 to $900 billion from the pension funds and other sources. The reader might ask what is the collateral for this borrowing? The investment banks would purchase mortgage securities with this borrowing and submit these same mortgage securities as collateral to the pension funds. The payments received from the home-owners on these mortgage securities would be used to first pay the interest on the borrowings from the pension funds, and the rest would be the profits of the investment bank. In view of the leverage ratio of 25 to 30, a net difference of only about 0.8% in the interest rate received from the home-owner and the interest rate paid to the pension funds would ensure a rate of return of 20% or more for the investment bank. However, the problem with this scheme is that the pension funds only had the trust-worthiness of the investment bankers and the mortgage securities as assurance against the money they lent out. Of course, they also had the enticement that only the Wall Street money-machine could provide them the rate of return adequate to keep up with their large pension payments to senior citizens.

With a fall in the house prices, there would be a corresponding fall in the mortgage securities due to the risk of foreclosures. Moreover, these mortgage securities were structured in such a way that foreclosures of mortgaged homes would be reflected in increasing degrees as one went lower down the tranches. Thus the lowest tranches would lose value very quickly in the event of a fall in house prices. So, the pension funds and mutual funds would need to assess the value of the mortgage securities in their accounting books periodically, say once every quarter, to safeguard their interests. For this, they would need refer to the market value of these securities (mark-to-market), and to request the investment bank to replenish the collateral, if there is a drop in the market value of the mortgage securities. Unfortunately, since the leverage was so high, an average drop of 3% in the market value of the mortgage securities could mean that after the pension fund's collateral was replenished, the whole amount of the capital of the investment bank ($20 to $30 billion) would have to be replaced. This was what led to the bankruptcy of some of the large investment banks. The story with smaller investment banks and the hedge funds is similar. Now, if the pension funds simply didn't insist on mark-to-market accounting, then the investment banks would receive regular payments on the mortgage securities from the home-owners. Over time, the pension funds would recover the full amount of their investment along with the rate of interest that the they had expected, with the only risk being that of foreclosures. There would be no risk that the prices of the mortgage securities would fall due to illiquidity in the markets. Thus financial meltdown would be avoided, with or without the existence of the Wall Street firms.

However, this argument turned out to be the Achilles' heel of the investment banks. Working in their old trust-based mentality, they thought they could ride through this financial crisis if they simply convinced their creditors to rescind the mark-to-market rule and give them more time. They didn't find it necessary to sell off the risky mortgage securities and cut their losses, nor were they seriously looking to raise new capital. And they were caught by surprise when the end came. For the same reasons cited above, the investment banks and hedge funds that survived found that their capital had been seriously eroded by this need to replenish their creditors' collateral. Hence the banks need to be re-capitalized. However, it is not clear that the government should do this re-capitalization through its $700 billion bill. Moreover, the surviving investment banks and hedge funds have realized that such high leverage ratios are not sustainable. So they would like to sell off the mortgage security and pay off some of their borrowings to the pension funds. But since they are all looking to sell off in the short-term, the prices of the mortgage securities are lower, which again requires further de-leveraging. This phenomenon is called the 'paradox of de-leveraging'. However, the real economy on Main Street need not wait for Wall Street to de-leverage. As I mentioned above, the financial meltdown would be avoided with or without the existence of the Wall Street firms. De-leveraging is solely Wall Street's problem, and it is highly unprofessional for Wall Street executives to keep sending out predictions of impending doom in the media.

Q5. Why have the markets for mortgage securities continued to remain illiquid?

A. The main reason that the markets for mortgage securities have been illiquid for a prolonged period of time is that the home-owner who is the only party with a credible and serious interest as a buyer of the mortgage securities has been shut out of the market. Instead of directly involving the home-owner, Wall Street has been peddling bizarre theories about risk management that has resulted in this huge mis-allocation of this $700 billion recently. By providing the information for a direct match-up of the home-owners on Main Street and the security-owners on Wall Street, the government could implement a low-cost eBay-type bidding system that would enable the home-owners to bid for the various tranches in the mortgage securities issued on their homes -- those tranches that the banks want to get rid of. This way the home-owners stand to benefit from a reduction in their debt obligations. The security-owners gets a floor on the prices of the mortgage securities and because of the decent prices, their capital gets replenished. Moreover, the home-owners' debt reduction can be structured in a way that encourages good behavior, and timely re-payment of the rest of the mortgage loan. This process would cost less than $1 billion for the government and achieves the objectives of liquidity and re-capitalization stated in the $700 billion bill. In addition, this direct match-up plan reduces foreclosures by reducing the home-owner's debt. Professor Martin Feldstein has also proposed a plan to reduce foreclosures. In his plan the government re-negotiates the home-owners' loans to provide debt reduction through low-interest loans, in return for enhanced claims on the home-owner. In my plan, the government's role is solely to provide reliable information.

Q6. What exactly is this great innovation of directing accumulated capital towards solving demographic problems that Wall Street has achieved?

A. Throughout history poor people have lived in subsistence conditions. Due to shorter life expectations than exist today, a poor man would have had to work for a living all his life. As mentioned above, the industrial economies of the 19th century Europe enabled the rise of a broad middle class with the means of hereditary wealth transfer and of supporting retired lifestyles. Contemporary times have raised the possibility that this access to wealth of a middle class standard could be further broadened to the whole of the population. Over the course of the 20th century, home-ownership had come to be a fundamental middle class aspiration throughout the world. In his "Lectures on Economic Growth", Professor Robert Lucas cites the travails of the characters in Sir V. S. Naipaul's "A House for Mr. Biswas" as the model for growth and development. Of course, I should also mention that Professor Lucas is more directly concerned with developing human capital rather than with home-ownership in his lectures quoted above.

Historically, massive accumulations of capital that are unrequited, have always been problematic. In addition, accumulation of capital has also resulted in the military-industrial complex. Professor Jeffry Frieden's "Global Capitalism: Its Fall and Rise in the Twentieth Century" is an excellent narration of how promises of global capitalism at the beginning of the 20th century quickly unraveled into the two World Wars. Thus matching the culturally and racially homogeneous retirement age population with the more diverse and younger home-owner population finds a gainful investment for the accumulated capital.

Q7. If Wall Street has been achieving all these great feats, where did it go wrong?

A. When concerns about the mortgage securities surfaced last year, many Wall Street investment firms claimed to be safe because they had not invested in sub-prime mortgages. This created a fear psychosis whence people began to consider these sub-prime mortgages as 'toxic'. The prime mortgage is one which meets the eligibility criterion for purchase by Fannie Mae and Freddie Mac. This includes a 20% down payment and good credit score. Those mortgages that don't meet this criterion were called sub-prime. Gradually, Fannie Mae and Freddie Mac also began to deal with these sub-prime mortgages. So, it didn't make sense to be denigrating sub-prime mortgages. Wall Street wasted a lot of time in late 2007 and early 2008 trying to discredit the sub-prime mortgages. In the modern economy, every single participant is beset with economic insecurity. So, the distinction between the prime and the sub-prime borrower, while it exists, is not really that great. Moreover, it is the sub-prime borrower who stands to gain the most by way of the development of human capital that Professor Lucas discusses in his "Lectures on Economic Growth". So, the sub-prime borrower would be the most willing, in the long-term, to highly value the inter-generational trade of wealth to support the senior citizens. Thus to discredit the sub-prime borrower has been the single major mistake that led to the financial crisis on Wall Street.

Q8. What are the lessons that can be drawn from the current financial crisis for government involvement?

A. Government's role is very important for avoiding crises, like the current one, in the future. The government should ensure that public transportation is available from home-owner colonies to their places of work. Most of the new single family homes are built in colonies of 100 or so, with whole neighbourhoods of new homes developed together. These new home colonies form suburban communities around cities and they are the symbols of affluence near towns. Because of their distance from the business districts, millions of these new home-owners drive their own cars to work. For example, it is not uncommon for software engineers and other professionals living near the Washington beltway to spend two or three hours on the road every working day, by way of commuting to work. Many of these new home colonies do not have frequent public transportation service. If the government would ensure that convenient and timely public transportation to their place of work is available, then this would save billions of dollars in oil expenses for America. Moreover, this way, the automobile would be seen as a luxury product, to be used in the evenings and in the weekends for entertainment, rather than as a necessity to get to work. This way the market for higher-end automobiles would benefit.

For people buying new homes, the government should ensure that they are fully informed about the economic and financial aspects of their investment. Equally importantly, they should not be overloaded with irrelevant, unreliable and unnecessary information. The best step would be ensure that the new home buyers are aware of the Case-Shiller Home Price Index. Currently this index is available only for 20 major American cities, and the data is collected for repeat sale homes, not new homes. But, being aware of this index is the best way new home-owners can be equipped for making financial decisions about their homes. The government should assist the managers of this price index financially so that they can gather empirical data for the prices of homes in all residential communities in America, not just on the 20 major cities. Apart from this, the government should ensure that low income people who are vulnerable to predatory lending are properly educated about the risks involved in sophisticated financial products, like adjustable rate mortgages.

Q9. What is the role of the Chairman of the US Federal Reserve Bank in finding a solution for this crisis?

A. As far as the Federal Reserve Bank is concerned, the most important and pressing need, at present, is for its Chairman, Professor Benjamin Bernanke to give a well-thought public speech that demonstrates that he understands the problems he is encountering in the markets. (I am still studying his speech given at National Association of Business Economists today. I would have more to say after I have studied his speech carefully). He has done a good job in injecting more than $1 trillion into the economy by way of short-term funds to provide liquidity. Moreover, I had given him high marks for his speech at Jackson Hole in August 22, 2008 in my "Update 3: Fire-sales, Bazookas and Hospitals" (dt. 8 Sep., 2008). It still seems that he is the only person in government who is thinking seriously about the current crisis. However, it appears that he has let himself be sidelined by the Secretary of the Treasury, Henry Paulson, who has exacerbated the crisis to global proportions through his Bazooka theory. The best service that Professor Bernanke can do for America is to recommend to the United States Congress that the spending of the $700 billion be postponed by three months.

The Federal Reserve would be well advised to restrict its actions solely to providing liquidity in the global financial system. In particular, changes in the Fed's interest rate are not advisable until a new government is sworn in. In this respect, one should note that one explanation for the persistent spread between the treasury yields and the inter-bank lending rates (TED spread) could be that the private banks, unlike the Fed, are not willing to lend money at real interest rates that are negative. This is a legitimate point, and it suggests that in fact it could be the Federal Reserve that has read the interest rate situation wrong. Then again, buying of commercial paper, as announced today (October 7) is ill-advised. More importantly, it is nearly a dereliction of duty to have approached the United States Congress for permission to spend $700 billion six weeks before a Presidential election. Professor Benjamin Bernanke had disassociated himself from this plan during his Congressional testimony, in fact, going to the extent of saying that he is just a college Professor, and has not worked on Wall Street and does not have any personal connections in the finance industry. The consensus among academic economists (as expressed by Professor Kenneth Rogoff) seems to be that the United States has a lot of money to spend, perhaps referring to the fact that countries in the rest of the world had their currencies seriously devalued in comparable situations like the East Asia crisis, the Russian crisis, Mexican crisis and the Latin American crisis. But, I should point out that $700 billion is about 5% of the annual GDP of the United States.

Q10. What is really ailing the American financial system? Doesn't the government need to intervene to salvage the situation?

A. The real problem is that the common man and the individual investor expect an honest and trust-worthy functioning of government. As I mentioned in my "Update 3: Fire-sales, Bazookas and Hospitals" (dt. 8 Sep., 2008), 'What the taxpayers (and the voters) within the United States, along with investors all over the world, most need to see, at this moment, is that there is a functioning legal (and legitimate) framework within which the financial markets play the role of enabling the process of economic decision-making towards optimal allocations of scarce resources'. At present, decision making at the government level has been taken over by vested interests. Both the Presidential candidates have promised to curtail the greed on Wall Street. The democrats have been complaining about executive compensation for many years now, and they have proposed government regulations of the finance industry in the future. The Republican candidate, Senator John McCain has openly called for the firing of the SEC Chairman Christopher Cox, and for prosecuting any fraudulent activities on Wall Street. This situation has given great jitters to Wall Street. So, the power mandarins on Wall Street have figured that they need to get the most they can before the current administration goes out of office at the end of the year. This seems to be the most credible explanation for their political activities of the last two months. However, I am no expert in political science, and I am just making my own conclusions based on my reading the news. The reader should consult a Political Science Professor on this question. My own point is that the government authorities have very little credibility, especially after the hilarious testimony to the US Congress two weeks ago. What is really ailing the American financial system, it seems to me, is a vacuum in the political leadership. Thus the role of the government in the current financial crisis should be minimized as much as possible until a new government is sworn in. The world runs on democratic principles much more than it does on fear of bazookas.